Common stock vs. preferred stock, which one should you invest in? This is one question that lingers on most investors’ minds. The truth is both are worthwhile investments. The difference is in their returns and your investment goals. Preferred stock is almost similar to bonds as investors earn fixed amounts of income in the form of dividends.
Conversely, investors of common stock earn income based on the company’s net income. If the company incurs a loss or fails to declare dividends, the investors won’t earn any income. However, investors of preferred stock are guaranteed an income whether the company makes an income or not.
In case the company reports a loss, preferred dividends are paid in the next financial period if the company earns an income. Understanding the difference between the two types of stock is essential for both investors and a company planning to raise capital. Here’s more about common stock vs. preferred stock.
What is Common Stock?
When an investor refers to a share in a company, they often refer to common stock. It represents an investor’s ownership in a company. Holders of common stock are often referred to as stockholders. They usually have voting rights which increase proportionally to the number of shares they own.
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It is these voting rights that enable them to vote corporate policies and elect the board of directors. Common shareholders earn high returns in the long term. However, in the event of a liquidation they are compensated after preferred shareholders, bondholders, and debtholders. It is this feature that makes a common stock a riskier investment than preferred shares.
When a company is issuing common stock, it announces an initial public offering where shares are sold to retail investors and institutional investors. Typically, one or more investment banks underwrite the IPO and determine the stock price. After the IPO stage, the public is allowed to purchase the new stock on a secondary market.
There are different types of common stock in a secondary market, and knowing the kind of stock on issue is critical to aligning the investment to your goals. Here’s a brief overview:
- Blue-chip stocks: These are stocks from companies with a long history of making dividend payments and sustained earnings. Such companies have already established leadership positions in their industries. Examples include those listed in the Dow Jones Industrial Average
- Income stocks: This kind yields a high dividend payout because the company is in the mature stage of its industrial life. However, the stock price may not increase exponentially as that of a blue-chip company. Real estate investment trusts and utility companies are good examples
- Growth stock: This kind is issued by companies expecting sustained growth in earnings and sales. Such companies often have high price/earnings ratios but hardly pay dividends. Google and Cisco Systems make excellent examples of growth stocks
What is Preferred Stock?
Similar to common shares, they are securities that represent ownership in a company. However, in this case, the shareholders have a priority claim over ordinary shareholders. Their dividends can be fixed or set based on a benchmark interest rate like London InterBank Offered Rate.
Unlike ordinary shares they don’t have voting rights but they are pretty flexible. Here are the different types of preferred stock:
- Convertible preferred stock: This kind can be converted to common stock
- Perpetual preferred stock: With this kind, the company doesnt fix a specific date when the shareholders will receive the invested capital
- Exchangeable preferred stock: The shares can be exchanged for another type of security
- The main reason companies offer preferred shares is to avoid diluting control. Since the shares don’t have voting rights, the company doesn’t share ownership with the new shareholders. Also, the preferred stock provides great flexibility because the company can decide the payment terms.
Differences: Common Stock vs. Preferred Stock
The differences of common stock vs. preferred stock are already evident, but this section provides a more detailed outlook:
1. Dividend Payment
A notable difference between common and stock preferred Stock is in dividend payment. Venture-backed companies, for example, rarely declare cash dividends, but preferred shareholders can negotiate dividends.
The amount of dividends is based on a percentage of the purchase price, usually 5-9%. Since such companies hardly pay dividends, the shareholders can only wait until the preferred stock is redeemed or sold to recover their monies.
For common shareholders, the dividends are paid out depending on the net income earned during that year. For example, Company A can pay out a dividend of $4 in quarter 1, but if it incurs a loss in Quarter 2, the company may fail to pay out dividends.
2. Liquidation Preference
As the name suggests, preferred stockholders are prioritized over common shareholders during liquidation. This feature is the most highly negotiated aspect of preferred stockholders. However, if the proceeds from the sale are enough for distribution to common and preferred shareholders, a liquidation preference isn’t necessary.
Preference shareholders have two liquidation preferences- participating preference and non-participating preference. Non-participating preference happens when the preferred shareholder receives more than the purchase price (plus accrued dividends). Alternatively, the shareholder gets the amount they would have received if the shares of the preferred stock are converted to common stock.
For example, a preferred shareholder buys 25% of the company at $10 million, and has non-participating preference. If the company is sold for $80 million the shareholder is entitled to $10 million in liquidation preferences but instead of receiving this amount, he receives $20 (25% * $80).
For the participating preference the shareholder is entitled to their liquidation preference and the amount if the stock is converted to common stock. Using the previous example, the shareholder receives $10 million of the liquidation preference and 25% of the remaining $70 million.
The right to participating preference may also be capped to a specific amount. As such, the preference shareholder gets the amount invested and what they’d have received if the preferred stock had been converted to common stock. However, this amount is negotiated to a maximum amount (usually 2-3 times of the original purchase price).
Most companies prefer negotiating for non-participating preferred stock during the first round of financing because it increases the probability of distributing funds to common shareholders. In case the company loses negotiation at the first attempt, future investors are likely to insist that their preferred stock includes participation rights.
3. Voting Rights
While common shareholders and preferred shareholders own a part of the company, only the former have voting rights. Preferred shareholders can only negotiate these two rights to influence the company’s transactions:
4. Board Composition
This is a highly-negotiated function in a company because the board of directors oversees a company’s management and determines its strategic decisions. Thus, the control of the board is a vital function for both investors.
As such, the leading preferred shareholder may seek one or more board seats. Common shareholders also seek representation on the board of directors depending on the number of seats preferred investors demand.
5. Protective Provisions
Preferred shareholders also negotiate for protective provisions requiring inclusion when making certain decisions. This means some decisions can only be approved if a certain number of preferred shareholders agree.
The premise for protective provisions is to grant preferred shareholders significant control over major decisions even if they own a minority share in the company.
6. Type of Investors
Preferred and common shareholders appeal to different kinds of investors. Common stocks are highly volatile hence tend to attract investors who want to build their portfolios quickly. They’re also appealing to research-savvy investors who know how to take advantage of the January effect (stock prices are higher in January). Conversely, preferred stocks are ideal for investors looking for a fixed and steady income.
7. Risk and Returns
Risk is another factor that differentiates common stock vs. preferred stock. Common stock is considered riskier because:
- It experiences price fluctuations
- Has an erratic payment schedule
- Lacks a set dividend amount
On the other hand, preferred stock makes a more stable form of investment because:
- It hardly experiences price fluctuations
- Has a fixed payment schedule
- Dividends are guaranteed
- Are prioritized during liquidation
Other Benefits that Accrue to Preferred Shareholders
Preferred shareholders enjoy the advantage of converting their shares to common stock at any time. Common shareholders don’t enjoy this right. The number of convertible shares are determined by dividing the purchase price by the conversion price. Typically, the conversion price is equal to the purchase price but is subject to change under particular circumstances.
Unlike common shareholders, preferred shareholders also enjoy preemptive rights. This right allows investors to purchase some of the securities a company proposes to sell. Normally the number of shares the investor can buy in the proposed financing is based on their ownership in the company.
It is essential to understand the differences between common stock vs. preferred stock because they affect an investor’s portfolio. Similarly, company executives should get acquainted with the implications of floating each type of share, especially during the first round of financing.